We pay income taxes on the money we earn.
Sometimes, we also make money by owning something that becomes more valuable before we sell it. When we sell something that increases (appreciates) in value, the government taxes us on the increase in value that we receive when we sell that something. The tax assessed against the money that is made from an asset increasing in value is called capital gains tax.
Capital gains taxes can discourage people from selling any property that has become more valuable since purchase. This outcome is not desirable in our society because the free conveyance of property between people helps ensure that property will be used for its highest, best and most beneficial purposes.
Therefore, the government has a process that sometimes allows for capital gains taxes to be delayed if the proceeds of the sale of an asset are reinvested in another asset. The part of the Internal Revenue Code that provides for this is Section 1031. This process is also sometimes called a Starker exchange or a like-kind exchange. The asset sold is called the relinquished property, and the asset acquired is called the replacement property.
In like kind exchanges, capital gains tax is not avoided. Rather, capital gains taxes may be delayed until the owner sells the replacement property.
The words “like kind exchange” hint that the process requires two people to evenly trade properties that are exactly the same in value for each other. However, that impression is not exactly accurate. The words “like kind exchange” communicate the fact that any one person is buying and selling like kind properties as a part of a single transaction.
There are three primary contexts within which a like kind exchange occurs. First, two people can agree to trade properties with each other simultaneously. In that situation particularly, the properties may not be equal to each other, and one or the other party may pay extra money to make the trade fair. The extra money is called “boot,” and the boot does not usually jeopardize most of the trade’s tax delaying attributes.
Second, an owner can sell relinquished property and then buy replacement property within 180 days of the sale of the relinquished property. There are many requirements, including participation of an independent “agent” to hold the seller’s money until it is invested in the replacement property. If proceeds from the sale of the relinquished property are actually possessed by the seller, it is not an “exchange,” and the tax is not delayed.
Third, replacement property can be purchased before the relinquished property is sold. This is called a “reverse 1031 exchange,” and it is generally perceived as difficult to administer in light of many understandably strict IRS’s requirements in that context necessary to avoid misuse/abuse.
People interested in like kind exchanges should consult and involve experienced real estate attorneys, because extensive and unintended tax liability can be incurred if there is even the slightest misstep in any aspect of administering a compliant exchange.
Lee R. Schroeder is an Ohio licensed attorney at Schroeder Law LLC in Putnam County. He limits his practice to business, real estate, estate planning and agriculture issues in northwest Ohio. He can be reached at Lee@LeeSchroeder.com or at 419-523-5523. This article is not intended to serve as legal advice, and specific advice should be sought from the licensed attorney of your choice based upon the specific facts and circumstances that you face.